Financial intermediation is the activity in which financial institutions incur liabilities by acquiring financial assets and engaging in monetary transactions in the market. The main goal of intermediation is to make profits and, at the same time, diversify risks. They also function to ensure maturity transformation where they take short term deposits and turn them into long term investments such as mortgages. In essence, financial intermediation involves financial intermediaries, which are firms that borrow from clients and lend to investors. It connects borrowers, lenders, and intermediaries, which is a vital aspect of capitalistic economies. The intermediaries include investing banks, insurance firms, mutual funds, and pension funds. They create a pool of funds to diversify risks and benefit from money managers' expertise as they invest in various investment ideas such as bonds, stocks, and real estate. The intermediation is vital because it brings surplus and those with insufficient funds together where groups can borrow and invest. These institutions' characteristics include borrowing from one source and lending to another, large lending and borrowing groups for risk diversification, and claims issued have different contingent payoffs. Advantageously, the intermediation provides entities with the opportunity to reduce costs through economies of scale that an individual would not access.
Four Types of Institutions that are Considered to be Financial Intermediaries
For investment banks, they act as intermediaries for complex and large transactions. They lend investors’ money and offer depositors interest or predetermined returns. Examples of such institutions include JP Morgan & Chase, the largest bank in America, and Citigroup. They offer community banking and various divisions that provide investment options.
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Also, mutual funds are institutions that use money from lenders and invest in other securities such as bonds and stocks. The investors buy shares in the companies, which represent their ownership into the company. Examples of such include the Vanguard Group and Charles Schwab.
For insurance companies bear risk on behalf of its contributors. They use funds received through premiums and channel them to various investment options in the financial market. They also bear the risks of other intermediaries in case of a loss. Examples include Berkshire Hathaway's direct insurance company and Liberty Mutual.
Commercial banks as financial intermediaries play a vital role in the economy. They package deposits into loans to firms who need the funds. Commercial banks also utilize analysts to examine the creditworthiness of firms in need of borrowing funds. With their access to vast sums of funds, they can diversify risks by offering loans and investing in other areas.
Differing Meanings of the Terms Liquidity and Valuation
Liquidity is the ease at which an asset can be converted into cash without adversely impacting the market. Money is the most liquid asset whose value depends on currency stability. For example, if a company sells its assets, liquidity value is what it receives at the end of the sale. Investments with lower liquidity mean they are more challenging to convert to cash, such as large plants. In contrast, assets such as bonds and stocks could easily be converted to currency. The types of liquidity include market liquidity and accounting liquidity. For the former, it ensures that a market can facilitate easy asset conversion. However, liquidity accounting indicates a company's capabilities to meet financial obligations with the available liquid assets. On the other hand, valuation refers to the estimation of worth for an investment or company. In a business, valuation can help determine sale value, business value, and ownership. Various valuation methods, such as market capitalization, times revenue method, Discounted Cash Flow (DCF) Method, and book value, the value of assets, and business are determined.
